Wednesday, October 01, 2008

The U.S. Senate has approved, by a vote of 74 to 25, a bailout bill. The House of Representatives voted down a similar bill on Monday by a narrow margin, and returns Thursday to consider another version (or versions).

The Senate tonight overwhelmingly passed the economic rescue package, or Wall Street bailout, as a way of forcing the House of Representatives to take a second vote on the bill, which it rejected in different form earlier this week. ...

Deliberations took place behind the scenes Wednesday, as senators added breaks and sweeteners to their version of the economic rescue plan. ...

The Senate modified the $700 billion financial rescue plan with a provision that gives the Treasury Department the authority to buy troubled mortgage securities.

The bill also now includes an extension of numerous tax breaks for research and development and renewable energy companies, as well as personal tax breaks for college tuition and disaster victims.

It proposes adjusting the Alternative Minimum Tax, so it doesn't hit more than 20 million middle class Americans in 2009.

In the run-up to the House vote earlier this week, economist Warren Coats published two commentaries on the proposed bailout -- one for the Cato Institute, one on his own blog.

The background to our current financial problems is that the United States as a whole is over-leveraged. There is too much debt and too little saving. Efficient borrowing/lending can be very beneficial, but too little saving for the whole country and for individuals during their working years reduces productive investment and the income growth it produces and increases the economy's vulnerability to shocks. As a nation our net savings rate became negative in 2005 and remained near zero until this year. This has been possible because of high savings rates in the rest of the world and the ability of foreign governments, firms and individuals to invest large amounts of these savings in the United States. Foreigners were willing to invest in the United States (largely in government and private sector debt and to a much lesser extent in equity) for only modest yields because of their confidence in the safety of U.S. investments and they were able to do so because our (previously) overvalued currency (the so called "strong dollar") created a large current account deficit (excess of imports over exports) that foreign investments in the U.S. helped finance.

The inflow of foreign savings has kept interest rates low in the U.S. in recent years. This is a so-called "real" rather than a "monetary" phenomenon. During the period from December of 2001 until November of 2004 the Federal Reserve's overnight interest rate (fed funds rate) target was below 2% and the unusually low interest rates of this period are thought to have fed the housing price bubble. Many have claimed that these low rates were the result of excessively easy monetary policy, but this claim is somewhat contradicted by the evidence. During this period of low interest rates, the broad measure of the money supply (currency plus the public's deposits with banks-M2) grew on average at 6.2%, exactly the same average rate as between 1980 and now. During the shorter period between December 2002 and June 2004, when the fed funds rate was below 1.25%, M2 grew on average at 6.1% per year. However, when the fed funds rate was above 5% from November 1994 through March of 2001 the average growth rate of M2 was 6.4%. The Federal Reserve's adjustments in its interest rate target were largely stabilizing the growth in the money supply. A significantly higher fed funds rate during the 2002 to 2004 period would have resulted in much lower if not negative M2 growth. Interest rates were determined largely by the inflow of foreign saving. Nonetheless, interest rates were negative in real terms (less than the inflation rate) and contributed to market exuberance. A slower than trend M2 growth (and thus higher fed funds rate) might have been more appropriate. Furthermore, M2 began growing in March of 2004, and the Fed should have begun increasing its Fed funds target rate sooner than it did.

Coats, who spent more than 25 years at the International Monetary Fund and has helped some two dozen emerging economies build their banking and currency systems, concludes in his Cato article (citations omitted):

It is appropriate for the government to intervene to restore or preserve stable financial market if doing so saves taxpayers money in the long run. However, such interventions should be well-targeted and should minimize to the extent possible creating moral hazard incentives for financial institutions to take risks with taxpayers' money. We are rapidly reaching the point where the creditworthiness of the United States government itself is coming into question as a result of the growing list of unfunded commitments it has made.

Both private sector and government debt has skyrocketed in recent years. Credit market debt stood at $2.3 trillion in 1990, $6.4 trillion in 2000 and $12.9 trillion at the end of 2007. U.S. government debt (leaving aside state and municipal debt) was $3 trillion in 1990 (51% of total national output that year), $5.8 trillion in 2000 (59% of GDP), and $9.5 trillion (69% of GDP) at the end of June this year. Twenty-eight percent of it ($2.6 trillion) is foreign owned. The Treasury and Federal Reserve have just added a potential additional trillion dollars to this debt with their various rescue actions and proposals. Annual interest on this debt at the 3.8% currently paid for 10-year government bonds (while below the average interest on the debt) would be almost $400 billion or about 14% of the total federal budget. This seems quite manageable until the true deficit including the unfunded liabilities of Medicare/Medicaid and Social Security is calculated. According to Richard Fisher, President of the Federal Reserve Bank of Dallas, these are ten times the existing debt. Interest payments on the full true debt would exceed total federal tax revenue. Existing government spending promises simply cannot be met. Some mix of reductions in existing entitlements and increases in tax revenue will be required. Our goal should be to minimize the negative impact on economic growth of that mix in order to maximize the additional government revenue arising from a higher tax base.

In a piece on his own blog, called "The Big Bailout: What Next?," Coats -- who was once an assistant professor of economics at the University of Virginia -- writes about a similar financial markets situation in Sweden in the 1990s and how the Swedes addressed it. He concludes:

No convincing evidence has been presented that existing liquidity and bank resolution tools are not up to the job of seeing us through the adjustments to earlier excesses now underway. As long as that remains the case the Federal Reserve and FDIC should continue to rely on them. Should fresh evidence indicate otherwise, the authorities should turn first to increasing deposit insurance limits, establishing a mortgage insurance agency (to replace Fannie Mae and Freddie Mac), and only as a last resort the injection of tax payer financed capital into (and thus government take over of) financial institutions judged too big to fail.

Both pieces by Warren Coats are well worth reading in their entirety. Some of the economic jargon might make hard slogging, but he does a good job of putting the current situation in perspective.